Leveraging Firm Entry Policy to Drive Innovation, Growth, and Reduce Income Inequality, in the Presence of Entry Threats and Rent-Seeking

This paper presents an analytical model that investigates the dynamics of rent-seeking, innovation, and entry policies in a two-sector economy characterized by skilled and unskilled labor. The model explores how incumbent firms in an intermediate goods sector react to the threat of new entrants and how rent-seeking behavior influences innovation and economic productivity. A key feature of the model is the role of a policymaker who sets firm entry policies and responds to bribes offered by incumbent firms seeking to restrict market entry. The analysis distinguishes between advanced and backward incumbent firms. Advanced firms, which operate at the frontier of technological productivity, choose to innovate to retain their competitive position in response to entry threats. In contrast, backward firms face higher barriers to innovation and are more likely to bribe policymakers to deter new competition. The magnitude of the bribes depends on the difference in profits with and without entry threats, as well as the costs of innovation. The model highlights how rent-seeking by backward firms distorts market competition, leading to suboptimal innovation and lower aggregate productivity in the skilled sector. Policymakers, balancing between maximizing bribes and addressing wage inequality, face conflicting incentives. If a policymaker prioritizes welfare, they may restrict entry to reduce wage inequality, thereby lowering competitive pressures and innovation. Alternatively, a policymaker focused on maximizing bribes may encourage higher entry threats, fostering innovation but exacerbating income inequality. This paper contributes to the literature on rent-seeking and economic growth by providing a nuanced understanding of how firm behavior, entry policies, and innovation are interlinked, with important implications for labor markets and income inequality. The model provides insights into the broader economic consequences of rent-seeking behavior and entry regulation, emphasizing the need for balanced policies that encourage innovation while minimizing economic distortions caused by rent-seeking activities.